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Fed, with bond taper on autopilot, free to tackle big questions

U.S. Federal Reserve chair Janet Yellen speaks to the Economic Club of New York in New York April 16, 2014. REUTERS/Brendan McDermid

By Ann Saphir and Jonathan Spicer

SAN FRANCISCO/NEW YORK (Reuters) - Federal Reserve policymakers this week are set to continue paring their massive bond-buying stimulus, but below the smooth surface of a likely unanimous vote lies a deeply divided Fed struggling to lay the groundwork for more difficult decisions ahead.

Fed Chair Janet Yellen hinted at the U.S. central bank's broad agenda a couple weeks ago when she laid out three "big" issues officials need to track: the level of slack in the labor market, whether inflation is rising back toward the Fed's 2 percent goal, and the factors that could derail the economic recovery.

Unexpected "twists and turns," she said, could force the Fed to diverge from its highly telegraphed plan to end asset purchases later this year and raise interest rates in 2015.

Yellen and her colleagues are debating what economic conditions would set the stage for a rate hike, whether the Fed should start letting its balance sheet shrink before or after it acts to push up borrowing costs, and whether it should respond to the possibility of asset bubbles in some markets.

Fed officials, who will meet on Tuesday and Wednesday, disagree sharply on the answers to these questions, and consequently on the best longer-term plan for rate rises. But unlike their counterparts at the European Central Bank, who face a threat of deflation, U.S. central bankers are under little pressure to pivot quickly on policy.

"We doubt any major change will emerge" in the Fed's policy statement, said Annalisa Piazza, fixed income strategist at Newedge. The statement, to be released at 2 p.m. (1400 GMT) on Wednesday, at the close of the meeting, will not be accompanied by new economic forecasts or a news conference, events that are only scheduled quarterly.

Recent data has largely borne out the Fed's presumption that a mid-winter slowdown in the economy was due to unusually severe weather. In addition, with bond yields down and stock prices up since the Fed began tapering its asset purchases in January, market conditions are not threatening to undercut the economy's momentum.

The relative stability makes it an easy call for the Fed to trim its monthly bond buying by $10 billion for a fourth consecutive meeting. This would take the purchases down to $45 billion and put the Fed about halfway along its plan to end the quantitative easing program by late this year.

And because officials completed a much-needed revamp of a low-rate promise last month, they can now take the time to dig into the longer-term strategy that will guide them when they finally begin raising rates.

RAISING RATES: "A MATTER OF FEEL"

At the last policy meeting in March, all but one official backed a new pledge to keep rates near zero for a "considerable time" after the bond-buying ends. The lone dissenter, Minneapolis Fed President Narayana Kocherlakota, has already signaled he will not continue to dissent.

Since then, a handful of officials have suggested the Fed should be more specific about when rates will rise. Boston Fed President Eric Rosengren has floated the idea of keeping rates near zero until the economy is within one year of reaching full employment and 2 percent inflation.

Richard Fisher, who heads the Dallas Fed, panned the idea. "It is a matter of feel," he told reporters in Austin earlier this month. "I don't think you can put a specific time frame on it. And I wish we could, but I don't think that would be responsible monetary policy."

Another question policymakers need to answer in coming months is whether a test facility for conducting reverse repurchase agreements, which temporarily drain cash from the financial system and could help control market rates when the Fed tightens monetary policy, will be adopted as a key tool.

The relatively quiet bond market "allows the Fed to reflect on big-picture themes," said Thomas Costerg, economist at Standard Chartered Bank. "There is mounting pressure to clarify the exit strategy and the role of some liquidity facilities, although it is unlikely that the Fed will decide this now."

(Additional reporting by Richard Leong in New York; Editing by Leslie Adler)